Talking About Investing: The Behavior Gap
Greetings, this is Carl from Behavior Gap. This morning I just wanted to introduce the concept of behavior gap and how it sort of evolved. It all really started with a problem. I read an article years ago in The Economist magazine that highlighted a study that the average mutual fund return was around 10.4 percent. . . I’m sorry, it was 10.7 percent—the average return for a mutual fund over a twenty year period. And that the average investor in those same mutual funds had had a return of 3.7.
And I was completely puzzled. How could it be possible that the average investment returned around ten and the average investor returned around four, let’s say. And we started. . . We started researching as to why. How could this have happened? How could the average investment. . . how could the average investor so dramatically underperform the average investment? And we started call that difference. . . we started sketching this on a white board with clients. Where we had one bar that had the average investment at about ten percent and another bar that had the average investor at about four percent. And we called the difference there the ‘behavior gap.’
I’m not sure it’s that it matters all that much exactly what the numbers are. Because that study just emphasized what we all in the industry and probably what we all as the investment public have known the whole time: we have a problem. Our investment experience—the experience we have in our own accounts—just never seems to match up with the returns we see touted in the media. And I wanted to know why.
So, I started looking into it and started understanding that it was really a behavior problem. We were making decisions to sell low and buy high. And the classic example, of course, is ‘97, ‘98, ‘99. You know, the NASDAQ is up 84% in 99. And in January, February and March money poured into Internet and technology funds, just before the market fell out and those funds were down fifty, sixty, seventy percent. Then then, when they were down, money poured out of those funds and into bond funds when bonds were at 46 year highs, just before bond funds went down ten percent. And then money flowed out of bond funds into emerging markets fund, just before emerging market funds got hit. And then money flowed into real estate. . . you. .. you know the story. We’ll sort of highlight some more of that story in some upcoming papers and even in a book we’re working on.
But the point is: This pattern has been happening forever. People have been. . . we have this tendency to want to buy things that have just done well and sell things that have just done poorly. The problem is that this rear-view mirror approach to investing has lead to us tending to chase recent trends—we call it “following the hot dot”—and it has lead us to dramatically underperform our own investments. And there’s a number of stories about that that we’ll include in upcoming papers.
So, that’s where we thought it ended, right? Let’s just educate people on how to avoid those mistakes. How to be smarter investors. How to be more aware of the emotional and behavioral impact on their investment returns. So, that’s what we set out to do initially. We’ll just educate people about these mistakes, try and get them to stop.
Then we realized over the last couple of years that this poor investment behavior is really a symptom of a larger problem. And that problem is lack of planning. People just have not really engaged in the financial planning process and there’s a lot of reasons for that: it’s been done poorly in the past, people have used financial planning as a ‘hook’ to sell products so a lot of the people in the financial planning industry, in the past—at least the one that’s marketed really heavily—a lot of people are just product salesmen ‘hiding’ as financial planners or disguised as financial planners. And on top of that, financial planning is difficult. I mean, it’s emotionally challenging to really sit down and analyze spending. And that is not something, you know, to analyze your spending and your investment habits, and that is not been something that we, in general, have done over the last ten years. Sort of. . . as evidenced be the fact that we have been spending in completely unsustainable ways. And that’s starting to catch up to us now.
So, we thought that this problem was just a problem in sort of education and behavior in investments and then we realized it’s really hard to behave correctly if you don’t have it tied to a plan that matches your goals. And then we realized, well, why aren’t people planning? People aren’t planning because planning has been poorly executed and often people think of financial planning really as “oh, that’s that guy who sells life-insurance.”
So, that’s sort of the introduction to the behavior gap and kind of the evolution of where we are now. So now really what we focus on a lot—we still talk about the behavioral mistakes people are making with their investments—but we also are focusing a lot on the impact that having a solid, financial planner involved in your life can make.
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